I am the co-founder of JobStats and Real Time Macroeconomics LLC, a financial technology firm that provides real-time, high frequency macroeconomic indicators of movements in the labor market derived from aggregated web scraped online data. I previously worked as a client portfolio management senior analyst at Goldman Sachs Asset Management in their Quantitative Investment Strategies (QIS) group, focusing on liquid alternative investments. Prior to that, I worked as an economic researcher at the Federal Reserve Bank of Chicago and as a statistician with the Dallas Cowboys. I also had a cameo in The Wolf of Wall Street and appeared on the film’s poster. I graduated with an A.B. in Mathematics and Economics with honors from the University of Chicago. You can follow me on Twitter at @Jon_Hartley_.

The author is a Forbes contributor. The opinions expressed are those of the writer.

The Fed's New Tool To Help Raise Interest Rates

With many expecting the Federal Reserve to raise interest rates sometime next year, what remains unclear is not just when the Fed will raise interest rates, but also how it will raise interest rates when the time comes. The Federal Funds Rate, the rate at which banks are paid interest by other banks for deposits held by the Fed, is well-known as the traditional rate for influencing borrowing costs though some at the Fed worry that it will be less effective in controlling short-term borrowing costs than in the past during a raising rate environment.

The Overnight Reverse Repurchase Agreement facility (often referred to as ON RRP) was created by the Fed in September 2013 as a program to allow financial institutions other than just banks (from broker-dealers to mutual funds) to have accounts at the Fed that pay interest. The idea is that such a facility would allow the Fed to control short-term rates more effectively through the adjustment of the rate of interest paid on both reserves held by banks and the overnight repos held by non-banks as part of the new program.

The program works through the use of tri-party repurchase agreements, but in essence, it is an interest paying account (backed by some collateral) that acts much like “reserves” deposited at the Fed, which are only available to traditional banks. Since no counterparty would be willing to lend funds into the market at a rate cheaper than what the Fed would pay, this rate together with the Federal Funds Rate would act as a floor rate for lending in the financial system, giving the Fed a wider net across the short-term rate market.

Bank Run Concern Over The Fed Overnight Reverse Repurchase Facility During a Crisis

Much debate exists around the kind of impact the Fed’s overnight reverse repurchase facility would have in a crisis.

In a recent WSJ op-ed, Shelia Bair argues that in the event of a widespread panic or another market meltdown, investors and other financial institutions would rather park their money at the Fed rather than at banks as a result of the new program, which she believes would cause a run on banks: “The mere existence of this facility could exacerbate liquidity runs during times of market stress… Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.”

This concern is echoed by many policymakers within the Fed. Regarding the reverse-repurchase agreement facility, Philadelphia Fed President Charles Plosser said,“More and more people are expressing reservations…there’s a lot of things that might happen to the plumbing of the money markets, and people have gotten…concerned that there’s a lot we don’t know”. Atlanta Fed President Denis Lockhart believes “The broad concern is whether we want to facilitate what could be a period of financial stress by providing in any sense an extremely large or unlimited refuge [for investors], and whether that would tend to exacerbate a financially stressful situation”.

John Cochrane: “The Fed would become a borrower of first resort”

John Cochrane, the AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, expressed considerable support for the program. His argument is that during a crisis like 2008 investors put their money in banks, who then use the money to buy reserves from the Fed. The Fed’s new overnight repo facility just takes “bankruptcy-prone intermediaries” out of this process since investors can directly put their money in the Fed. Effectively, the Fed would become a “borrower of first resort” according to Cochrane. He also points out that overnight repo developed as a financial product largely to provide a safer version of “deposits” in quantities larger than deposit insurance allows. The Fed’s new overnight repo program would allow investors to lend to the Fed directly without deposit insurance limits being imposed.

Concern Over Money Market Mutual Funds And The Overnight Repo Program

The other question is concern around how money market mutual funds (in the midst of adopting their own new post-crisis reforms) would operate with the existence of a new program. In 2008, the Reserve Fund, the nation’s oldest money market fund, broke the buck, due to holding debt issued by Lehman Brothers. Bair argues that the new Fed overnight repo program exacerbates “systemic risk emanating from money-market funds”. Cochrane however makes a distinction that it was “prime” money market funds, which held short term debt issued by risky banks and other financial institutions that failed in 2008. Money market funds that hold government debt on the other hand were completely safe and run-proof. Even if we were to repeat the crisis with the aid of a Fed Overnight Repo Program, Cochrane argues that “prime” money market funds holding privately issued debt by defunct banks like Lehman “could not suddenly switch to holding interest-paying reserves” because they’d have to sell all their worthless paper first. Cochrane argues that at the end of the day, to create real money market fund reform, the Fed and the SEC should encourage money market funds to hold either Treasuries or interest-paying reserves under the new program which would provide the same level of safety and reduce the risk of “breaking the buck” that poses systemic risk.

The Real Question Is How Big Will The Fed’s Overnight Repurchase Program Be?

What will ultimately define the Fed’s overnight repo program is its scale, which will ultimately be determined by the Fed over the next year as it begins to raise rates. Whether the Fed chooses to open the overnight repo program on an unlimited scale or keep deposits at the Fed limited (the more likely scenario given publicly expressed concern at the Fed over systemic risk) is the major question policymakers will be asking regarding the fate of the new program that began last September.

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